Financial Innovation and Disruption: The Effect of Investment Flows to Exchange-Traded Funds on the Traditional Mutual Fund Industry

Abstract

Exchange-traded funds (ETFs) have several key competitive advantages in the market for investor capital that would appear to make these investment vehicles a threat to the traditional mutual fund industry. To investigate whether historical investment flows to ETFs have indeed disrupted mutual fund flows, I estimate the effect of changes in flows to the ETF industry on changes in flows to mutual funds using a series of time and entity fixed effects regression models and data from the Center for Research in Security Prices for the period from 1999-2017. Through this primary analysis, I find the unexpected result that an increase in the change in flows to ETFs leads to a corresponding increase in the change in flows to mutual funds. More specifically, key estimations show that a $1 million increase in net flows to the ETF industry leads to a $93 to $219 increase in net flows to the average mutual fund, which equates to a $2.2 to $5.3 million increase in net flows to the mutual fund industry. This primary result therefore suggests a level of complementarity between ETFs and mutual funds. I also conduct a secondary analysis of the non-ETF drivers of mutual fund flows, finding evidence for cost-sensitive, return-chasing investor behavior.